I am a retired tough love angel who is tough when the situation calls for it but otherwise expects smart people to find their way with soft love.

Guest Post: Top Four Things To Consider In Shareholders’ Agreement

Editor’s note: This is a guest post by Jukka Kallio, the CEO of KallioLaw (www.kalliolaw.fi) and ranked in 2011 top 100 M&A lawyers in the world, an angel investor and startup advisor.

If you are looking the latest post in the Nokia Startups Mistakes series, you can find it from here.

Below are few key points that I would like to address when you are drafting a Shareholders’ Agreement (“SHA”). These things may not apply to all companies, but for sure to the start-ups:

1) In general, big mistakes can be avoided if you do not build wrong incentives in the SHA, such as granting one stockholder a right to block something important or allowing a group of stockholders to use such provisions only for their own benefit. I have seen many times that provisions that were initially intended for some specific scenario, are used in other context for the benefit of one or several stockholders.

2) Working obligation: for start-ups the human resources are vital and that is why the working obligation of the founders and possible other key employees are agreed in the SHA. Think about how long you want to require others to work for the company and how long you are willing to be committed yourself. And of course, the working obligation should be in line with the company’s business objectives. Many times I have seen provisions that do not really specify the working obligations, e.g. whether it should be full time based, require meeting certain milestones or raising funds, etc. The more detailed you discuss on these things the less problems you typically face in the future.

Also – as always when setting obligations –, it is important to agree what are the penalties if one does not comply with his/her working obligations. Think about what should happen if one is not complying with it? If nothing is agreed the breaching stockholder should compensate damages but it is not easy to prove such damages. In the worst case scenario, the breaching stockholder will have the right to keep his/her shares and no damages can be proven! The vesting of the shares will resolve these kinds of things easily and it is discussed in the next bullet.

3) Vesting: in the SHA of a start-up in which working commitments are required, i.e. in all start-ups in fact, the circumstances may change in the company or in the family of stockholder, etc. This means that we need to answer to a question “what happens to such stockholder’s shares in a start-up who agreed to work for the start-up but is not doing it? Typically it is agreed in the SHA’s of start-ups that there is a time period during which one will “earn” his/her shares. But, it is important to avoid wrong incentives – as discussed above – which would allow the leaving stockholder the right to keep all his/her shares. It would be very demotivating to the remaining stockholders and would be a typical “free rider” issue.

So, if you agree on working obligations, set also vesting for the shares that are aligned with the set time frames, milestones or reaching other targets. A good vesting provision will make sure that all working stockholders are treated reasonably and fairly but also prevents “free rider” issue.

4) Decision-making: many times in the SHA’s there are provisions on what qualified majority is required for fund raising (issuing new shares to investors or others). However, that will not mean that the start-up can in practice raise funds. Even if your start-up can issue shares to an investor, you may not be able to complete it because a shareholder will not agree to sign the new SHA required by an investor thus blocking the fund raising. You should always think what actions are needed to be able to execute things that are agreed in higher levels in the SHA’s. I have seen cases where a start-up has raised funds and investor requires new SHA but there are one or more minority stockholders who refuse doing so and, thus, block the start-up getting funded. Not an optimal situation! It should be discussed and agreed in the SHA when the start-up and stockholders may force other stockholders to execute and be bound with the same contracts than the others – however, being fair and avoiding wrong incentives in the SHA.